Downside Protection For Arena Pharmaceuticals

Arena Spikes On Narrower Than Expected Loss

Shares of Arena Pharmaceuticals ARNA closed up 17.4% on Friday after reporting a narrower than expected third quarter loss. For investors looking to add downside protection on Friday, ARNA was too expensive to hedge against a greater-than-20% drop over the next several months using put protection, but it was possible to hedge using a collar.

1) Hedging With Optimal Puts

Uncapped upside, but unavailable in this case.

As of Friday's close, it was too expensive to hedge ARNA against a greater-than-20% drop over the next several months with optimal puts* (i.e., taking into account the cost of the put protection, it wasn't possible to limit your losses to no greater than 20%). Incidentally, this was true as well of another biotech stock that reported yesterday, Celldex Therapeutics CLDX.

Because of that, we were presented with the error message above.

2) Hedging With An Optimal Collar

1.46%. 20% upside cap.

If you were willing to cap your potential upside at 20% between now and April 18th, this was the optimal collar** to hedge 1000 shares of ARNA against a greater-than-20% drop over the same time frame.

As you can see at the bottom of the screen capture above, the net cost of this collar, as a percentage of position value, was 1.46% (recall that in the case of CLDX yesterday, the net cost of hedging it was negative).

Note that, to be conservative, Portfolio Armor calculated the cost of this hedge by using the bid price of the call leg and the ask price of the put leg. In practice, you can often sell calls for more (at some price between the bid and ask) and buy puts for less (again, at some price between the bid and ask), so, in actuality, an investor opening the optimal collar above may have paid less than $70 to hedge in this case.

Possibly More Protection Than Promised

In some cases, hedges such as the ones above can provide more protection than promised. For a recent example of that, see this post about hedging shares of Tesla Motors, Inc. TSLA.

*Optimal puts are the ones that will give you the level of protection you want at the lowest possible cost. Portfolio Armor uses an algorithm developed by a finance PhD to sort through and analyze all of the available puts for your stocks and ETFs, scanning for the optimal ones.

**Optimal collars are the ones that will give you the level of protection you want at the lowest net cost, while not limiting your potential upside by more than you specify. The algorithm to scan for optimal collars was developed in conjunction with a post-doctoral fellow in the financial engineering department at Princeton University. The screen captures above come from the Portfolio Armor iOS app.